Equity Multiples

The PE ratio is the most commonly used equity multiple (it was first introduced in the 1930s). Data availability is one reason why: earnings, both historical and forecast, are easily available.

Earnings are, however, subject to different accounting policies. We recommend using adjusted earnings in calculating the ratio; UBS Warburg defines ‘adjusted’ earnings as earnings before exceptional items and goodwill amortization.

Price to earnings multiples cannot be used when earnings are negative. As an alternative, use normalized earnings or calculate a forward-priced multiple.

Use this multiple when earnings are representative of future earnings and the trend in those earnings. For example, if there are significant write-offs in a year, earnings are unlikely to be representative. Use pre-exceptional or pre-extraordinary earnings instead.

As far as possible, use for comparisons of companies, sectors and markets that have similar accounting policies. Alternatives are to adjust earnings to a common basis across sectors and markets; or to use earnings before the most material distorting items such as depreciation and goodwill amortization.

Different capital structures will affect multiples because of the gearing effect on earnings; two companies with identical operating profit may have widely different earnings. One alternative approach is to use NOPLAT or tax-adjusted earnings before interest.

An important weakness of the PE ratio is that it does not explicitly take into account balance sheet risk (although it is implicitly incorporated into the underlying cost of equity).
Furthermore, the PE ratio does not explicitly take into account the amount of investment required to support future growth. You can, however, take this into account indirectly.

Cash earnings are usually defined as simply net profit plus depreciation & amortization. This is a rough and frequently misleading measure of cash flow, as it ignores the many other factors that affect cash flow, including changes in net debt, changes in working capital and so forth.

This problem is magnified when using prospective cash earnings, because of the additional complications involved in forecasting changes in net debt; the estimated capital structure can have a large impact on forecast earnings.

Furthermore, historical cash flow can be a very volatile.

As a result, price to cash earnings is difficult to use as a base valuation measure.

Price to cash earnings should be used as a supplement to other measures, particularly in conjunction with multiples that are unadjusted for accounting differences between comparables, where those differences are material.

Price to book value is a useful measure where tangible assets are the source of value generation. Because of its close linkage to return on equity (price to book is PE multiplied by ROE), it is useful to view price to book value together with ROE.

Using this measure with industrial companies requires care because net assets are based on historical cost book value, an unreliable indicator of economic value.

Book values are not directly comparable where accounting policies cause them to deviate markedly from economic substance, nor are they directly comparable among companies with differing accounting policies. For example, book value would not be comparable between a company that revalues its assets (permitted under international accounting standards) and one that does not (revaluation is not permitted under US GAAP).
Ideally, book value should be adjusted for these differences. Some adjustments that might be made include:
— Stripping out revaluation surpluses on the basis that it is more practical than attempting to revalue all comparables
— Restoring excess depreciation (or deducting inadequate depreciation)
— Restoring accumulated goodwill amortisation and written-off goodwill
— Restoring the LIFO reserve, etc

This ratio is most widely used in valuing financials, especially banks, which squeeze a small spread from a large base of assets (loans) and multiply that spread by utilising high levels of leverage (deposits). Return on equity is therefore an important criteria in valuing bank stocks.